Steepening Yield Curve – Disaster or Recovery?

Wait a second, aren’t we suffering from the worst financial crisis in some seven decades; our GDP (Gross Domestic Product) is imploding; real estate prices are cratering; and we are hemorrhaging jobs faster than we can say “bail-out”? We hear it every day – our economy is going to hell in a hand basket.

If Armageddon is indeed upon us, then why in the heck is the yield-curve steepening more than a Jonny Moseley downhill ski run? Bears typically point to one or all of the following reasons for the rise in long-term rates:

Printing Press: The ever-busy, government “Printing Press” is working overtime and jacking up inflation expectations.

All these explanations certainly hold water; however, weren’t these reasons still in place 3, 6, or even 9 months ago? If so, perhaps there are some other causes explaining steepening yield curve.

One plausible explanation for expanding long-term rates stems from the idea that the bond market actually does integrate future expectations and is anticipating a recovery. Let us not forget the “inverted yield curve” we experienced in 2006 (see Chart ABOVE) that accurately predicted the looming recession in late 2007. Historically, when short-term rates have exceeded long-term rates, this dynamic has been a useful tool for determining the future direction of the economy. Now we are arguably observing the reverse take place – the foundations for recovery are forming.

Treasury Yield Curve (June 2009)

Alternatively, perhaps the trend we are currently examining is merely a reversal of the panic rotation out of equities last fall. If Japanese style deflation is less of a concern, it makes sense that we would see a rebound in rates. The appetite for risk was non-existent last year, and now there have been some rays of sunlight that have glimmered through the dark economic clouds. Therefore, the selling of government guaranteed securities, which pushed prices down and yields upward, is a logical development. This trend doesn’t mean the equity markets are off to the races, but merely reflects investors’ willingness to rotate a toe (or two) back into stocks.